IFRS 16 Leases

In January 2016, the new standard about lease accounting IFRS 16 was
issued and it introduced a few major changes. The most significant are:

 New definition of the lease can cause that some contracts

previously treated as “service contracts” can now be treated as
“lease contracts”,
 Accounting for leases in the lessee’s financial statements changed
and lessees do not classify the lease anymore. Instead, they should
account for all the leases in the same way.

I wrote an article highlighting these changes and illustrating them on

examples some time ago, but you might want to check that out here.
In this article, I’d like to sum up the main requirements of the new IFRS
16 and you’ll find a video in the end.

Why IFRS 16 Leases?

The objective of the standard IFRS 16 Leases is to specify the rules for
recognition, measurement, presentation and disclosure of leases.

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But, why is there a new lease standard when we had an older IAS 17
Leases?
The main reason is that under IAS 17, lessees were still able to hide
certain liabilities resulting from leases and simply not present them on
the face of the financial statements.
I’m talking about operating leases, especially those with non-cancellable
terms.
Under the new standard, lessees will need to show all the leases right in
their statement of financial position instead of hiding them in the notes
to the financial statements.

What is a lease under IFRS 16?

A contract is or contains a lease if it conveys the right to control the use
of an identified asset for a period of time in exchange for
consideration (IFRS16, par.9).

This definition of lease is much broader than under the old IAS 17 and
you must assess all your contracts for potential lease elements.
You should carefully look at:

 Can the asset be identified? E.g. is it physically distinct?

  Can the customer decide about the asset’s use?
 Can the customer get the economic benefit from the use of that
asset?
 Can the supplier substitute the asset during the period of use?

If the answer to these questions is YES, then it’s probable that your
contract contains a lease.
As I wrote in my article about comparison of IFRS 16 and IAS 17, the
impact of this new broader definition can be quite big, because some
service contracts (with payments recognized directly in profit or loss)
can now be considered as lease contracts (with necessity to recognize
right-of-use asset and lease liability).
Under IFRS 16, you need to separate lease and non-lease components in
the contract.
For example, if you rent a warehouse and rental payments include the
fees for cleaning services, then you should separate these payments
between the lease payments and service payments and account for these
elements separately.
However, lessee can optionally choose not to separate these elements,
but account for the whole contract as a lease (this applies for the whole
class of assets).

Accounting for leases by lessees

Warning: Lessees do NOT classify the leases as finance or operating
anymore!
No classification!
Instead, lessees account for all the leases in the same way.

Initial recognition
At lease commencement, a lessee accounts for two elements:

1. Right-of-use assetInitially, a right-of-use asset is measured in the

amount of the lease liability and initial direct costs.Then it is
adjusted by the lease payments made before or on commencement
date, lease incentives received, and any estimate of dismantling
and restoration costs (remember IAS 37).
2. Lease liabilityThe lease liability is in fact all payments not paid at
the commencement date discounted to present value using
the interest rate implicit in the lease (or incremental borrowing rate
if the previous one cannot be set).These payments may include
fixed payments, variable payments, payments under residual value
guarantees, purchase price if purchase option will be exercised, etc.

Let me outline the journal entries for you:

1. Lessee takes an asset under the lease:

o Debit Right-of-use asset
o Credit Lease liability (in the amount of the lease liability)
2. Lessee pays the legal fees for negotiating the contract:
o Debit Right-of-use asset
o Credit Suppliers (Bank account, Cash, whatever is
applicable)
3. The estimated cost of removal, discounted to present value (lessee
will need to remove an asset and restore the site after the end of the
lease term):
o Debit Right-of-use asset
o Credit Provision for asset removal (under IAS 37)
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Subsequent measurement
After commencement date, lessee needs to take care about both elements
recognized initially:

1. Right-of-use asset
Normally, a lessee needs to measure the right-of-use asset using
a cost model under IAS 16 Property, Plant and Equipment.It
basically means to depreciate the asset over the lease term:
o Debit Profit or loss – Depreciation charge
o Credit Accumulated depreciation of right-of-use asset
However, the lessee can apply also IAS 40 Investment Property (if
the right-of –use asset is an investment property and fair value
model is applied), or using revaluation model under IAS 16 (if
right-of-use asset relates to the class of PPE accounted for by
revaluation model).

2. Lease liability
A lessee needs to recognize an interest on the lease liability:
o Debit Profit or loss – Interest expense
o Credit Lease liability
Also, the lease payments are recognized as a reduction of the lease
liability:
o Debit Lease liability
o Credit Bank account (cash)
If there is a change in the lease term, lease payments, discount rate
or anything else, then the lease liability must be re-measured to
reflect all the changes.
 

Is this too complicated? Exemptions exist!

If you got this far in reading this article, maybe you find it
overcomplicated, especially for “small” operating leases.
Here’s the good news:
You do NOT need to account for all leases like described above.
IFRS 16 permits two exemptions (IFRS 16, par. 5 and following):

1. Leases with the lease term of 12 months or less with no purchase

option (applied to the whole class of assets)
2. Leases where underlying asset has a low value when new (applied
on one-by-one basis)

So, if you enter into the contract for the lease of PC, or you rent a car for
4 months, then you don’t need to bother with accounting for the right-of-
use asset and the lease liability.
You can simply account for all payments made directly in profit or loss
on a straight-line (or other systematic) basis.

Accounting for leases by lessors

Nothing much changed in accounting for leases by lessors, so I guess
you already are familiar with what follows.

Classification of leases
Unlike lessees, lessors need to classify the lease first, before they start
accounting.
There are 2 types of leases defined in IFRS 16:
 1. A finance lease is a lease that transfers substantially all the risks
and rewards incidental to ownership of an underlying asset.
2. An operating lease is a lease other than a finance lease.

IFRS 16 (IFRS 16, par. 63) outlines examples of situations that would
normally lead to a lease being classified as a finance lease (and they
are almost carbon copy from older IAS 17):

1. The lease transfers ownership of the asset to the lessee by the end

of the lease term.
2. The lessee has the option to purchase the asset at a price that is
expected to be sufficiently lower than the fair value at the date of
the option exercisability. It is reasonably certain, at the inception of
the lease, that the option will be exercised.
3. The lease term is for the major part of the economic life of the
asset even if the title is not transferred.
4. At the inception of the lease the present value of the lease
payments amounts to at least substantially all of the fair value of
the leased asset.
5. The leased assets are of such a specialized nature that only the
lessee can use them without major modifications.

Accounting for finance lease by lessors

Initial Recognition
At the commencement of the lease term, lessor should recognize lease
receivable in his statement of financial position. The amount of the
receivable should be equal to the net investment in the lease.
Net investment in the lease equals to the payments not paid at the
commencement date discounted to present value (exactly the same as
described in lessee’s accounting) plus the initial direct costs.
The journal entry is as follows:
  Debit Lease receivable
 Credit PPE (underlying asset)
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Subsequent Measurement
The lessor should recognize:

1. A finance income on the lease receivable:

o Debit Lease receivable
o Credit Profit or loss – Finance income
2. A reduction of the lease receivable by the cash received:
o Debit Bank account (Cash)
o Credit Lease receivable
Finance income shall be recognized based on a pattern
reflecting constant periodic rate of return on the lessor’s net investment
in the lease.
IFRS 16 then also specifies accounting for manufacturer or dealer
lessors.

Accounting for operating lease by lessors

Lessor keeps recognizing the leased asset in his statement of financial
position.
Lease income from operating leases shall be recognized as an income
on a straight-line basis over the lease term, unless another systematic
basis is more appropriate.
Here you can see that the accounting for operating leases
is asymmetrical: both lessees and lessors recognize an asset in their
financial statements (it’s a bit controversial and there were huge debates
around).

Sale and Leaseback transactions

A sale and leaseback transaction involves the sale of an asset and the
leasing the same asset back.
In this situation, a seller becomes a lessee and a buyer becomes a lessor.
This is illustrated in the following scheme:

Accounting treatment of sale and leaseback transactions depends on

the whether the transfer of an asset is a sale under IFRS 15 Revenue
from contracts with customers.

1. If a transfer is a sale:
o The seller (lessee) accounts for the right-of-use asset at the
proportion of the previous carrying amount related to the
right-of-use retained. Gain or loss is recognized only to the
extend related to the rights transferred. (IFRS 16, par.100)
 o The buyer (lessor) accounts for a purchase of an asset under
applicable standards and for the lease under IFRS 16.
2. If a transfer is NOT a sale:
o The seller (lessee) keeps recognizing transferred asset and
accounts for the cash received as for a financial liability
under IFRS 9 Financial Instruments.
o The buyer recognizes a financial asset under IFRS 9
amounting to the cash paid.

The final word

IFRS 16 prescribes a number of disclosures in the notes to the financial
statements.
I’d also like to point out that you have to apply IFRS 16 for the periods
starting on or after 1 January 2019 (careful about the comparatives).
You can apply IFRS 16 earlier than that, but only if you apply IFRS 15
Revenue from Contracts with Customers, too (the reason is that these 2
standards are closely related).
Please check out IFRS 16 Leases in the following video: